Finally, People Are Calling For A REAL Housing-Market Fix: Letting Prices Fall

Robert ShillerLong-term real house prices (inflation adjusted) -- blue line

For the past few years (and, in reality, for decades before that), the government has tried to improve the nation's housing market by artificially inflating house prices.

The mortgage-mod programs, the back-door bank bailouts, the Fed-subsidized mortgage rates, the $150 billion flushed down the Fannie and Freddie rat-hole--all these tactics and more have been designed to reduce monthly payments for mortgage holders and keep house prices high.

And while high house prices are obviously appealing to anyone who owns a house, they also shaft everyone who doesn't.

Importantly, these policies also shaft anyone who wants to buy a house...

* And anyone who has responsibly accumulated savings that are currently earning nothing thanks to the government's zero-interest-rate policies.

* And anyone who might like to invest savings in something that might earn something--like fairly priced housing.

* And even anyone who bought more house than they can afford but are hanging on to it in the hope that the government will sucessfully bail them out--instead of cutting their losses and moving on with their lives.

But three years into the bailouts, people are finally throwing up their hands. As the administration tries to figure out what to do to save the Democrats in November, calls for a new form of housing action are emerging: STOP trying to keep house prices artificially high and just let prices fall. (See this article by David Streitfeld in the New York Times.)

In other words, stop screwing the majority of the country that didn't borrow huge amounts of money from 2005-2007 to buy houses it couldn't afford, and just let the market heal itself.

How would the government do this?

Any number of ways.

By letting mortgage prices and loan requirements rise to normal levels. By trimming the Fannie/Freddie subsidies. By figuring out a simple mechanism whereby banks can reduce principal on mortgages in exchange for equity interests in the houses. By squelching all talk of future housing tax credits. Etc.

And what would this do?

Well, in the short-term, if house prices fell to fair value (5% to 10% below today's level--see chart below), it would certainly lead to more folks walking away from their mortgages. It would also, thereby, lead to more bank writeoffs. But that's only fair. And the banks now have enough capital (and enough access to capital), so they'll be able to survive.

Importantly, it would also allow a new generation of home buyers to step into the market and buy with the confidence that they won't get screwed if the government ever does decide to stop pumping up prices. (This is a big and justifiable fear.) Instead, new buyers will be able to look at long-term price-to-income and price-to-rent ratios and observe that they are buying houses at fair value or below--instead of at levels that are still artificially inflated relative to almost all non-bubble history.

It would allow renters who have heretofore been priced out of the market to buy for the first time.

It would force banks to clean up their balance sheets faster.

It would encourage consumers to clean up their own balance sheets faster.

It would restore sales velocity to the housing market, which would help the vast communities of real-estate related industries get back on their feet--thus helping reduce unemployment.

It would restore the government's firepower, allowing for modest, temporary intervention if it ever became desirable down the road (instead of prolonging the flooring-it-just-to-stay-steady current situation).

In short, in exchange for a modest amount of short-term pain for some banks and a minority of Americans (those underwater on their mortgages), it would help the country's housing market heal itself faster. And, in so doing, it would help the majority of the country, by helping our economy more quickly get back on its feet again.

Here's a larger version of Robert Shiller's long-term house price chart. Note that prices (blue line) are still modestly above the long-term average:

Robert ShillerLong-term real house prices (inflation adjusted) -- blue line